Download Energy Economics – II Jeffrey Frankel Harpel

Coping with Commodity Volatility:
Macroeconomic Policies
for Developing Countries
Jeffrey Frankel
Harpel Professor of Capital Formation & Growth
May 24, 2013
In 2008, the government of Chilean President Bachelet
& her Finance Minister Velasco ranked low in public opinion polls.
By late 2009, they were the most popular in 20 years. Why?
Evolution of approval and disapproval of four Chilean presidents
Presidents Patricio Aylwin, Eduardo Frei, Ricardo Lagos and Michelle Bachelet
Data: CEP, Encuesta Nacional de Opinion Publica, October 2009, www.cepchile.cl.
Source: Engel et al (2011).
2
Commodity exporters face extra
volatility in their terms of trade

Choices of macroeconomic policies &
institutions can help manage the volatility.

Too often, historically, they have exacerbated it:

Pro-cyclical macroeconomics
(i) capital flows, money, credit;
 (ii) currency policy; relative price of nontraded goods;
 and (iii) fiscal policy.

3
(i) Pro-cyclical capital flows

According to intertemporal optimization theory,
capital flows should be countercyclical:



In practice, it does not always work this way.
Capital flows are more procyclical than countercyclical.


flowing in when exports do badly
and flowing out when exports do well.
Gavin, Hausmann, Perotti & Talvi (1996); Kaminsky, Reinhart & Vegh
(2005); Reinhart & Reinhart (2009); and Mendoza & Terrones (2008).
Theories to explain this involve
capital market imperfections,

e.g., asymmetric information
or the need for collateral.
4
(ii) Pro-cyclical monetary policy

If the exchange rate is fixed,

surpluses during commodity booms can lead to:
Rising reserves
 Excessive money & credit
 Excess demand for goods; overheating
 Inflation
 Asset bubbles.

5
Macro effects of commodity boom

Inflation shows up especially
in non-traded goods & services,
like construction.
6
Pro-cyclical real exchange rate
Countries undergoing a commodity boom experience
real appreciation of their currency

The resulting shift of land, labor & capital
out of manufacturing, and into the booming
commodity sector might be
appropriate & inevitable,



to the extent it is expandable,
especially if the commodity boom is permanent.
But the shift out of manufacturing into NTGs is
often an undesirable macroeconomic side effect –

the “disease” part of Dutch Disease.
7
(iii) Procyclical fiscal policy

Fiscal policy has historically tended
to be procyclical in developing countries

especially among commodity exporters:
Cuddington (1989), Tornell & Lane (1999), Kaminsky, Reinhart &
Végh (2004), Talvi & Végh (2005), Alesina, Campante & Tabellini
(2008), Mendoza & Oviedo (2006), Ilzetski & Végh (2008), Medas
& Zakharova (2009), Gavin & Perotti (1997).


Correlation of income & spending mostly positive –

in comparison with industrialized countries.
8
Correlations between Gov.t Spending & GDP
1960-1999
procyclical
Adapted from Kaminsky, Reinhart & Vegh (2004)
countercyclical
G always used to be pro-cyclical
for most developing countries. 9
The procyclicality of fiscal policy

A reason for procyclical public spending:
receipts from taxes & royalties rise in booms.
The government cannot resist the temptation
to increase spending proportionately, or more.

Then it is forced to contract in recessions,

thereby exacerbating the swings.
10
Two budget items account for much
of the spending from oil booms:

(i) Investment projects.

Investment in practice may be
“white elephant” projects,

which are stranded without funds
for completion or maintenance
when the oil price goes back down.


Gelb (1986).
Rumbi Sithole took this photo
in “Bayelsa State
in the Niger Delta,in Nigeria.
The state government
received a windfall of money
and didn't have the capacity
to have it all absorbed in
social services so they decided
to build a Hilton Hotel.
The construction company
did a shoddy job, so the tower
is leaning to its right and
it’s unsalvageable..”
(ii) The government wage bill.

Oil windfalls are often spent on public sector wages.


Medas & Zakharova (2009)
Arezki & Ismail (2010):
government spending rises in booms, but is downward-sticky.
11
The procyclicality of fiscal policy, cont.

An important development -some developing countries, including
commodity producers, were able to break
the historic pattern in the most recent decade:

taking advantage of the boom of 2002-2008


to run budget surpluses & build reserves,
thereby earning the ability to expand
fiscally in the 2008-09 crisis.

Chile, Botswana, Malaysia, Indonesia, Korea…

How were they able to achieve counter-cyclicality?
12
Correlations between Government spending & GDP
2000-2009
procyclical
Frankel, Vegh & Vuletin (2012)
countercyclical
In the last decade,
about 1/3 developing countries
switched to countercyclical fiscal policy:
Negative correlation of G & GDP.
13
Four questions for macro management

1. How can a country avoid excessive credit creation
& inflation in a commodity boom ?

Eventually allow some currency appreciation.
 But not a free float. Accumulate some fx reserves first.


2. Nominal anchor for monetary policy:
What is it to be, if not the exchange rate? CPI?

3. Fiscal policy:
How can governments be constrained from
over-spending in boom times? Fiscal rule?

4. What microeconomic arrangements
can reduce macroeconomic volatility?
14
1) The challenge of designing
a monetary regime for countries where
terms of trade shocks dominate the cycle

Fixing the exchange rate
leads to pro-cyclical monetary policy:

Money flows in during commodity booms.



Excessive credit creation can lead to inflation.
Example: Saudi Arabia & UAE during the 2003-08 oil boom.
Money flows out during commodity busts.


Credit squeeze can lead to excess supply,
recession & balance of payments crisis.
Example: Exporters of oil & other commodities
in 1980s or 1997-98.
15
Currency regime,

Floating accommodates terms of trade shocks:

If terms of trade improve,
currency automatically appreciates,


preventing excessive money inflows, overheating & inflation.
If terms of trade worsen,
currency automatically depreciates,


continued
preventing recession & balance of payments crisis.
Disadvantages of floating:


Volatility can be excessive;
Dutch Disease can be worse:


pro-cyclicality of real exchange rate.
One needs a nominal anchor.
16
Demand vs. supply shocks

An old wisdom regarding the source of shocks:



One set of supply shocks:
natural disasters


Fixed rates work best if shocks are mostly
internal demand shocks (especially monetary);
floating rates work best if shocks tend to be
real shocks (especially external terms of trade).
R.Ramcharan (2007) finds floating works better.
A common source
of real shocks: trade.
Terms-of-trade variability

Prices of crude oil and other agricultural & mineral
commodities hit record highs in 2008 & 2011.

=> Favorable terms of trade shocks for some

=> Unfavorable terms of trade shock for others


(oil producers, Africa, Latin America, etc.);
(oil importers such as Japan, Korea).
Textbook theory says a country where trade shocks
dominate should accommodate by floating.
Confirmed empirically:


Developing countries facing terms of trade shocks do better
with flexible exchange rates than fixed exchange rates.
Broda (2004), Edwards & L.Yeyati (2005),
Rafiq (2011), and Céspedes & Velasco (2012)…
Céspedes & Velasco (Nov. 2012)
NBER WP 18569
“Macroeconomic Performance During Commodity Price Booms & Busts”
** Statistically
significant
at 5% level.
Constant term
not reported.
(t-statistics in
parentheses.)
Across 107 major commodity boom-bust cycles,
output loss is bigger the bigger is the commodity
price change & the smaller is exchange rate flexibility.
19
Monetary regime
If the exchange rate is not
to be the monetary anchor, what is?

The popular choice
of the last decade:
Inflation Targeting.

But CPI targeting can react perversely
to supply shocks
 & terms of trade shocks.

20
Needed:
Nominal anchors that accommodate the shocks
that are common in developing countries


Supply shocks,

e.g., droughts, floods, hurricanes:

Nominal GDP targeting.
Terms of trade shocks

e.g., fall in price of commodity export.

Product Price Targeting
PPT
21
Nominal GDP target
cancels out velocity shocks (vs. M target)
& moderates effects of supply shocks (vs. IT)
P
Nom.
GDP
target
IT
•
Adverse
AS shock
AS
•
•
AD
Real
GDP 22
Does Nominal GDP target give best output/inflation trade-off?
Adverse AS shock
P
Nom.
GDP
target
IT
•
•
It gives exactly the right answer
if the simple Taylor Rule’s equal
weights accurately capture what
discretion would do.
Even if not exact, the “true”
objective function would have
to put far more weight on P than
output, or AS would have to be
very steep, for the P rule to give
a better outcome.
AD
Real GDP
23
Product Price Targeting
PPT
accommodates terms of trade shocks
Target an index of domestic production prices
[1]
such as the GDP deflator.
•
Include export commodities in the index
& exclude import commodities,
• so money tightens & the currency appreciates
when world prices of export commodities rise
• accommodating the terms of trade -• not when prices of import commodities rise.
•
The CPI does it backwards:
• It calls for appreciation when import prices rise,
• not when export prices rise !
[1] Frankel (2011, 2012).
24
Why is PPT better than a fixed exchange rate
for countries with volatile export prices?
PPT

If the $ price of the export commodity goes up,
the currency automatically appreciates,


moderating the boom.
If the $ price of export commodity goes down,
the currency automatically depreciates,


moderating the downturn
& improving the balance of payments.
25
Why is PPT better than CPI-targeting
for countries with volatile terms of trade?
PPT

If the $ price of imported commodity goes up,
CPI target says to tighten monetary policy
enough to appreciate the currency.



Wrong response. (E.g., oil-importers in 2007-08.)
PPT does not have this flaw .
If the $ price of the export commodity goes up,
PPT says to tighten money enough to appreciate.


Right response. (E.g., Gulf currencies in 2007-08.)
CPI targeting does not have this advantage.
26
Elaboration on
Product Price Targeting


PPT
Each of the traditional candidates for nominal
anchor has an Achilles heel.
The CPI anchor does not accommodate
terms of trade changes:

IT tightens M & appreciates when import prices rise
not when export prices rise,
 which is backwards.
 Targeting core CPI does not much help.

27
6 proposed nominal targets and the Achilles heel of each:
Vulnerability
Targeted
variable
Gold standard
Commodity
standard
Price
of gold
Price of agric.
& mineral
basket
Vulnerability
Example
Vagaries of world
1849 boom;
gold market
1873-96 bust
Shocks in
Oil shocks of
imported
1973-80, 2000-11
commodity
Monetarist rule
M1
Velocity shocks
US 1982
Nominal income
targeting
Fixed
exchange rate
Nominal
GDP
$
Measurement
problems
Appreciation of $
Less developed
countries
(or €)
(or € )
CPI
Terms of trade
shocks
Inflation targeting
EM currency crises
1995-2001
Oil shocks of
1973-80, 2000-11
Professor Jeffrey Frankel
Is Inflation Targeting
the reigning orthodoxy
at the Fund?
“Yes”
•
•
•
•
2006:
2007:
2008:
2010:
•
2011
100%
63%
72%
58%
97%
Do you personally
believe in IT? 38%
3. How Can Countries Avoid
Pro-cyclical Fiscal Policy?

“Good institutions.”

But what are they, exactly?
30
Who achieves counter-cyclical fiscal policy?
Countries with “good institutions”
”On Graduation from Fiscal Procyclicality,”
Frankel, Végh & Vuletin; J.Dev.Economics, 2013.
31
The quality of institutions varies,
not just across countries, but also across time.
1984-2009
Frankel, Végh
& Vuletin,2013.
32
The comparison
holds not only
in cross-section,
but also across time.
”On Graduation from
Fiscal Procyclicality,”
Frankel, Végh & Vuletin;
J. Devel. Econ., 2013.
33
How can countries avoid fiscal expansion in booms?

What are “good institutions,” exactly?

Rules?

Budget deficits or debt brakes?


Rules for cyclically adjusted budgets?


Have been tried many times. Usually fail.
Countries more likely to be able to stick with them.
But…
An under-explored problem:

Over-optimism in official forecasts

of growth rates & budgets.
34
Over-optimism in official forecasts

Statistically significant bias among 33 countries




(2011, 2012).
If the boom is forecast to last indefinitely,
there is no apparent need to retrench.
BD rules don’t help.




Frankel
Leads to pro-cyclical fiscal policy:


Worse in booms.
Worse at 3-year horizons than 1-year.
The SGP worsens forecast bias for euro countries.
Cyclically adjusted rules won’t help the bias either.
Frankel & Schreger
(2013).
Solution?
35
The example of Chile’s fiscal institutions


1st rule – Governments
must set a budget target,
2nd rule – The target is structural:
Deficits allowed only to the extent that



(1) output falls short of trend, in a recession, or
(2) the price of copper is below its trend.
3rd rule – The trends are projected by 2 panels
of independent experts, outside the political process.
 Result: Chile avoided the pattern of 32 other governments,

where forecasts in booms were biased toward optimism.
36
Chilean fiscal institutions

In 2000 Chile instituted its structural budget rule.

The institution was formalized into law in 2006.

The structural budget surplus must be…


0 as of 2008 (was higher before, lower after),

where “structural” is defined by output & copper price
equal to their long-run trend values.
I.e., in a boom the government can only spend
increased revenues that are deemed permanent;
any temporary copper bonanzas must be saved.
37
The Pay-off

Chile’s fiscal position strengthened immediately:


Public saving rose from 2.5 % of GDP in 2000 to 7.9 % in 2005
allowing national saving to rise from 21 % to 24 %.

Government debt fell sharply as a share of GDP
and the sovereign spread gradually declined.

By 2006, Chile achieved a sovereign debt rating of A,

several notches ahead of Latin American peers.

By 2007 it had become a net creditor.

By 2010, Chile’s sovereign rating had climbed to A+,


ahead of some advanced countries.
=> It was able to respond to the 2008-09 recession.
38

In 2008, with copper prices spiking up,
the government of President Bachelet had been
under intense pressure to spend the revenue.



She & Fin.Min.Velasco held to the rule, saving most of it.
Their popularity fell sharply.
When the recession hit and the copper price came
back down, the government increased spending,
mitigating the downturn.

Bachelet & Velasco’s
popularity reached
historic highs by the time
they left office.
39
Poll ratings
of Chile’s
Presidents
and Finance
Ministers
And the
Finance
Minister?:
August 2009
In August 2009, the
popularity of the
Finance Minister,
Andres Velasco,
ranked behind only
President Bachelet,
despite also having
been low two years
before. Why?
Chart source: Eduardo Engel, Christopher Neilson & Rodrigo Valdés, “Fiscal Rules as Social Policy,” Commodities Workshop, World Bank, Sept. 17, 2009
40
5 econometric findings regarding bias toward
optimism in official budget forecasts.

Official forecasts in a sample of 33 countries
on average are overly optimistic, for:



(1) budgets &
(2) GDP .
The bias toward optimism is:



(3) stronger the longer the forecast horizon;
(4) greater in booms
(5) greater for euro governments under SGP budget rules;
41
US official projections have been over-optimistic on average.
42
Greek official forecasts have always been over-optimistic.
43
Chile’s official forecasts have not been over-optimistic.
44
The optimism in official budget forecasts is
stronger at the 3-year horizon, stronger among
countries with budget rules, & stronger in booms.
Frankel, 2010, “A Solution to Fiscal Procyclicality:45
The Structural Budget Institutions Pioneered by Chile.”
5 more econometric findings regarding bias
toward optimism in official budget forecasts.

(6) The key macroeconomic input for budget forecasting in
most countries: GDP. In Chile: the copper price.

(7) Real copper prices revert to trend in the long run.
But this is not always readily perceived:


(8) 30 years of data are not enough
to reject a random walk statistically; 200 years of data are needed.

(9) Uncertainty (option-implied volatility) is higher
when copper prices are toward the top of the cycle.

(10) Chile’s official forecasts are not overly optimistic.
It has apparently avoided the problem of forecasts
that unrealistically extrapolate in boom times.
46
In sum, institutions recommended
to make fiscal policy less procyclical:

Chile is not subject to the same bias toward overoptimism in forecasts of the budget, growth, or the
all-important copper price.

The key innovation that has allowed Chile
to achieve countercyclical fiscal policy:


not just a structural budget rule in itself,
but rather the regime that entrusts to two panels
of experts estimation of the long-run trends
of copper prices & GDP,

insulated from political pressure & wishful thinking
47
Application to others

Any country could emulate the Chilean mechanism,


or in other ways delegate to independent agencies.
Suggestion: give panels more institutional independence

as is familiar from central banking:


laws protecting them from being fired.
Open questions:

How much of the structural budget calculations are
to be delegated to the independent panels of experts?


Minimalist approach: they compute only 10-year moving averages.
Can one guard against subversion of the institutions (CBO) ?
48
4. Other reforms to manage volatility

Contractual provisions to share risks:
1. Index contracts with foreign companies
to the world commodity price.
2. Hedge commodity revenues
in options markets.
3. Denominate debt in terms of commodity price .

Manage commodity funds professionally.
49
Manage commodity funds professionally.
Norway’s Pension Fund

All govt. oil revenues go into it.
Govermnent (on average over the cycle)
can spend expected real return, say 4%.
 All invested abroad.
Reasons:



(1) for diversification,

(2) to avoid cronyism in investments.
But insulated from politics,

like Botswana’s Pula Fund,

fully delegated for financial optimization.
50
References by the author

Project Syndicate,



http://www.hks.harvard.edu/fs/jfrankel/
“Escaping the Oil Curse,” Dec.9, 2011.
"Barrels, Bushels & Bonds: How Commodity Exporters Can Hedge Volatility," Oct.17, 2011.
“The Natural Resource Curse: A Survey of Diagnoses and Some
Prescriptions,” 2012, Commodity Price Volatility and Inclusive Growth in Low-Income
Countries , R.Arezki et al., eds. (IMF); HKS RWP12-014.

“How Can Commodity Exporters Make Fiscal and Monetary Policy Less
Procyclical?” in Natural Resources, Finance & Development. R.Arezki, T.Gylfason & A.Sy,
eds. (IMF), 2011. HKS RWP 11-015.

“On Graduation from Fiscal Procyclicality,”
with C.Végh & G.Vuletin, in Journal of
Development Economics, 100, no.1, Jan.2013; pp. 32-47.
NBER WP 17619. Summary, VoxEU, 2011.

Chile's Countercyclical Triumph," in Transitions, Foreign Policy, June 2012.

“A Solution to Fiscal Procyclicality: The Structural Budget Institutions Pioneered


by Chile,”
Central Bank of Chile WP604, 2011. Spanish:Journal Economía Chilena , Aug.2011, CBC, 39-78.
"Product Price Targeting -- A New Improved Way of Inflation Targeting,"
in MAS Monetary Review XI, 1, 2012 (Monetary Authority of Singapore).
“A Comparison of Product Price Targeting and Other Monetary Anchor
Options, for Commodity-Exporters in Latin America," Economia, 2011
(Brookings), NBER WP 16362.
51
References by others




Rabah Arezki and Kareem Ismail, 2010, “Boom-Bust Cycle, Asymmetrical
Fiscal Response and the Dutch Disease,” IMF WP/10/94, April.
Christian Broda, 2004, "Terms of Trade and Exchange Rate Regimes in
Developing Countries," Journal of International Economics, 63(1), 31-58.
Luis Céspedes & Andrés Velasco, 2012, “Macroeconomic Performance
During Commodity Price Booms & Busts” NBER WP 18569, Nov.
Graciela Kaminsky, Carmen Reinhart & Carlos Vegh, 2005, "When It Rains,
It Pours: Procyclical Capital Flows and Macroeconomic Policies," NBER
Macroeconomics Annual 2004, 19, pp.11-82.

Warwick McKibbin & Kanhaiya Singh, “Issues in the Choice of a Monetary
Regime for India,” 2003, in Kaliappa Kalirajan & Ulaganathan Sankar (eds.) Economic Reform
and the Liberalisation of the Indian Economy (Edward Elgar Publ., UK), pp. 221-274.


James Meade, 1978, “The Meaning of Internal Balance,” The Economic
Journal, 91, 423-35.
Jeffrey Sachs, “How to Handle the Macroeconomics of Oil Wealth,” 2007,
in Escaping the Resource Curse, M.Humphreys, J.Sachs & J.Stiglitz, eds. (Columbia Univ.
52
Press: NY), pp. 173-93.
53